Foreign exchange, acronymed as forex or FX, is the marketplace where almost all the national currencies are traded. It is a virtual electronic network of banks, brokers, institutions, and individual traders who most of the times trade through these brokers or banks.
The forex market is very large in size by its trading volume. According to the Bank for International Settlements, trading in foreign exchange markets averaged $6.6 trillion per day in April 2019. The largest foreign exchange markets are located in major global financial centers like London, New York, Singapore, Tokyo, Frankfurt, Hong Kong, and Sydney. The Indian rupee regulated by the Reserve Bank of India is the 20th most traded currency worldwide with a volume of approximately US$53 billion. It is traded daily in spot and futures trade.
A Brief History:
With evidence of coinage exchange appearing in Ancient Egypt in early 259 BC, forex trading can be considered to be that old. Florence’s Medici family opened banks in foreign locations to facilitate trade and exchange currencies on behalf of textile merchants in the 15th century, and during the 17th and 18th centuries Amsterdam maintained an active forex market where exchange took place between agents from England and Holland.
Modern forex trading started only in the later decades of 19th century. The biggest event in the history of currency trading happened in the 1870s, with the creation of the Gold Standard Monetary System. Foreign exchange holdings in international finance increased by 10.8%, while holdings of gold increased by only 6.3%, marking the importance of the emerging forex market during the period of 1899 to 1913.
Then the famous Bretton Woods Accord was signed in 1944, allowing currencies to fluctuate within a range of ±1% from the currency’s par exchange rate. Eventually, 1973 marks the beginning of the contemporary forex market, when state control of foreign exchange ended and floating currency and relatively free market conditions began.
When you go long (It is a basic term in trading, which refers to the ‘buying’ of security) on a currency pair, you actually buy the base currency and short sell the quote currency. In forex it takes 2 currencies to form a pair: base currency and quote currency. In EUR/USD, EUR is the base currency – the first part of the ‘equation’ – and USD is the quote currency – the second part of the ‘equation’.
For example, if you go long 100,000 units on EUR/USD, you are buying 100,000 Euros and short selling 100,000 US Dollars.
Short selling (this term refers to the ‘borrowing’ of security from the broker and selling it at the current market price. You can consider this to be the opposite of long.) in the forex market is quite different from that in the stock market. In the forex market, when you short sell a currency pair, you will be selling the base currency and buying the quote currency. Hence, short selling in forex is the same as placing a regular sell order.
However, the main motive remains that the prices must decline from the point you executed the short position to generate a profit. For example, if you short 10,000 units of USD/CAD, you are actually selling 10,000 US Dollars and buying the same number of Canadian Dollars. Hence, here, you’re not borrowing a certain amount of currency to go short.
With the concept of the long and short sell, we can make a profit from it. To profit from a long trade, you need the currency pair prices to increase. To profit from a short trade, you need the currency pair prices to decline.
This also implies that, in a long trade, an increase in the base currency prices will put you in profit, and in a short trade, a decrease in the base currency prices will give you profits.
Consider the current market price of USD/CHF to be 0.9850. Let’s say you went long on this currency pair. The buy/sell mechanism here is simple – you bought the USD (the base currency) and simultaneously short sold the CHF (the quote currency). Hence, to make a profit from this, you need currency pair prices to increase, which in turn means that you need the value of the base currency (USD) to increase or the value of the CHF to decrease because you’ve bought the USD.
The fluctuations in the value of currencies give birth to the risk involved in this market. Any appreciation/ depreciation of the base currency or the depreciation/ appreciation of the denominated currency will affect the cash flows emanating from that transaction. Foreign exchange risk can also affect investors who trade in international markets, and businesses engaged in the import/ export of products or services to multiple countries. This risk can be managed and minimised by option, future and forward trading.
—The writer is from Waghama, Bijbehara, currently doing Masters in Financial Economics from Madras School of Economics, Chennai.